Hedge funds try to hold back redemption wave

Tensions rise as some managers try to lock up investors' money for longer

By

AlistairBarr

SAN FRANCISCO (MarketWatch) -- Hundreds of hedge funds will shut this year as an estimated wave of as much as $700 billion in investor redemptions crashes over the industry, but some managers are trying to hold back the tsunami.

However, the trend is also raising tension between hedge fund investors, who may need cash quickly, and managers, who may be more interested in holding on to assets to protect their businesses.

'It's a fine line between managers acting to preserve the value of portfolios for investors and acting to protect their own interests.'
Christopher Addy, Castle Hall

"It's a fine line between managers acting to preserve the value of portfolios for investors and acting to protect their own interests," said Christopher Addy, chief executive of Castle Hall Alternatives, which advises investors on the operational risks of hedge funds. "It's a very difficult situation and I don't think there's a right or wrong answer."

Hedge funds have been hammered this year by the mortgage-fueled credit crisis, which has triggered a rush for cash across global financial markets. The average fund has lost a record 16% so far this year and investors withdrew $40 billion in October leaving industry assets at $1.56 trillion, according to Hedge Fund Research. See full story.

Between $650 billion and $700 billion may be withdrawn from hedge funds by the end of this year, Empirical Research Partners estimated this week.

Even funds that have performed relatively well this year are seeing redemptions. That's partly because managers with big losses have already halted withdrawals. So investors who need cash quickly are being forced to redeem from any fund that's still offering an exit.

"There's a lot of pressure from high net worth and private banking clients redeeming," said Antonio Munoz-Sune, chief executive of EIM Management (USA), a unit of EIM Group which manages $15 billion in funds of hedge funds. "Throw that into the mix and you're seeing good hedge funds facing redemptions of up to 30% of assets under management in a market with no liquidity."

"That's a fatal combination," he added.

Top managers may be able to suspend redemptions, giving them time to raise cash slowly or wait for markets to recover, while "mediocre" managers will have to shut down, Munoz-Sune explained.

Best approach

The best approach is for managers to pro-actively suggest a reorganization that locks up investor money for longer and offers lower fees in return. This still gives investors some control over the situation, Castle Hall's Addy said.

Jana Partners LLC, a big activist hedge fund firm run by Barry Rosenstein, is facing redemptions that may exceed 20% of assets under management. Instead of putting up a gate, the firm proposed a new share class that that will lock up investors' money for two years initially, but will charge lower fees. See full story.

Another manager said he gave some investors back as much as 20% of their money during the summer and again in September. These investors were endowments and other institutions that may have been struggling with private-equity commitments and may have needed the cash.

The manager was also concerned that his hedge funds were too exposed to these types of investors and wanted to diversify clients. He declined to be identified for this story.

Fait accompli

Many other firms have simply announced that they are suspending redemptions and restructuring their funds.

RAB Capital postponed redemptions from its Special Situations fund for three years after big losses. Before the change, investors could withdraw each quarter, with 180 days notice. Now they will have to wait until Oct. 3, 2011 to get their money.

The firm also halted redemptions on its smaller Deephaven International Volatility Strategies funds after redemption requests totaled almost two-thirds of assets.

GLG Partners
GLG, +0.00%
suspended redemptions from some of its hedge funds and put up a gate to limit withdrawals from its GLG European Long-Short fund in October. The moves locked up more than $1 billion of investor money that may have been redeemed at the end of 2008.

New Star Asset Management Group (NSAM) said Wednesday that it suspended dealing in shares of its New Star International Property Fund. The fund manager said it couldn't estimate now long the suspension will last.

Castle Hall's Addy declined to comment on specific firms, but he said the growing trend of redemption suspensions and restructurings is a problem because investors aren't given much of a choice and lose control over their money.

"Investors are looking for good communication from their managers, not simply a fait accompli," he said.

Managers vs. investors

Firms, including RAB, Deephaven, GLG and New Star, have said suspending redemptions protects investors because liquidating portfolios quickly would probably trigger even bigger losses. Investors often agree.

"I wouldn't want managers selling assets at fire sales prices to meet redemptions," Bill Ferrell, head of hedge fund investment firm Ferrell Capital Management, said in an interview. "This is not a good time to be trying to get out of major positions, especially illiquid securities."

However, some hedge funds are suspending redemptions even though most of the assets could probably be sold relatively quickly without incurring too many more losses, other investors said, on condition of anonymity.

Instead, managers of these funds may be locking up investors' money so they can keep collecting fees to run their businesses, the investors explained. Without longer lockups, managers would have to sell all the assets and shut down.

Right now, it's difficult to know who is right. If markets rebound, the assets hedge funds are holding may become more valuable again. But some of the assets may never recover.

"For those funds that have more unilaterally prevented investors from redeeming, history will prove whether that was actually necessary or just protective of the managers' businesses," Addy said.

Pardus Capital Management suspended redemptions in late March because it wanted more time for investments to be realized. See full story.

Pardus had positions in Delta Air Lines Inc.
DAL, -5.19%
United Airlines parent UAL Corp.
UAL, -3.32%
and has been active in the automotive industry, with positions in General Motors
GM, -2.10%
Delphi Corp.
DPHIQ
and Visteon Corp.
VC, -1.63%

Delta shares have slipped just 2% since the end of March. But GM stock has slumped 75% and Visteon is down 86%. Delphi and UAL are off almost 50%.

'Honorable'

One way to tell whether hedge fund managers are suspending redemptions for the right reasons is by looking at the new fees they charge in return for longer lockups.

"Some managers are extremely honorable and will take a cut in fees after suspending redemptions," Munoz-Sune said.

RAB said it would charge a 1% annual management fee and a 15% performance fee after locking up investors in its Special Situations fund for three years. That's down from fees of 2% and 20% before.

Gates can be useful too, Munoz-Sune and Ferrell said.

These are imposed if investors ask to redeem more than a certain amount of assets from a hedge fund, usually about 20% of assets under management. When these levels are breached, funds can limit total withdrawals and investors will only get back a portion of the money they asked for.

For instance, if a $100 million fund has a 25% gate and investors representing half of the assets redeem, each investor would get half of the cash they requested. Withdrawals would be limited to $25 million, which means the manager has to unwind fewer positions.

Centaurus Capital, a London-based hedge fund run by Bernard Oppetit, put up a gate in October that means investors can withdraw up to 10% of their money. Longer-term, the firm proposed a two-year lockup in return for lower fees and the chance for investors to redeem as much as 30% of their money.

Gates are usually part of the offering documents investors read before committing money, so when managers use them, investors are more understanding, Addy said.

But even gates have drawbacks.

"Some managers who are putting up gates are not necessarily punishing the investors who are staying, but the problem they face is that their portfolio may have a large portion of illiquid investments," Munoz-Sune said. "They may sell marketable securities first, leaving the remaining investors with a fund that holds an even higher proportion of illiquid securities."

Mis-match

What all this ultimately comes down to is a realization that hedge funds were investing in assets that were too illiquid, while offering investors the chance to withdraw too often. This liquidity mis-match is being brutally corrected now.

"A lot of people fooled themselves for a long time," said Mitchell Kaye, managing director at Navigant Capital Advisors, which advises distressed financial institutions including hedge funds. Some hedge fund managers and investors "were probably aware that they were not as liquid as they should have been."

Addy reckons hedge fund fees may change in future to match the investment horizon of the manager. If a fund doesn't plan to sell an asset for two years, investors should only be required to pay a performance fee once profit from that position is realized, he explained.

"At a very minimum, there is an argument that incentive fees should not be paid over a period shorter than the redemption frequency available to investors," Addy wrote in a research paper earlier this month.

"If a fund has a three-year lock up, for example, it seems logical that the manager should not receive any incentive fee until the three-year mark, which is the first opportunity for investors to decide whether they want to retain capital with the firm," he explained.

Addy also questioned whether hedge funds should be structured and sold as open-ended investment products.

An open-ended hedge fund is forced to value its assets monthly, even when some holdings don't trade much, making them difficult to value. Private-equity style funds or closed-end vehicles may be more appropriate in future, he said.

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